Risk Will Not Equate To Reward For The Near Future

The vertical climb of the S&P seems to have plateaued. We are into April and the rallies that emanated from the panicked rush of underinvested hedge funds, and the end-of-quarter window dressing by the same funds has all slowed down.

Now, we are into the seesaw between an optimism about a full recovery, and the anxiety of corporate earnings of companies facing a faltering Europe and an unknown China situation. When faced with emotional seesaws, statistics can sometimes enlighten. So let's look at what the market has done in the months following a steep S&P rise of 28% or more, such as the front end of 2012. Figure 1 below, is a table from the technician Laszlo Birinyi's blog (Source: Birinyi Associates) provides a very useful historical perspective on how the market has done in past periods of substantial rise.

Click to enlarge(Click to enlarge)

Figure 1. History - What the market did after a 28% (or more) rise

Taken at face value, this is mildly bullish, as it suggests that you have better than even odds of making money (certainly outperforming money markets and bonds) in 1,3 and 6 month time frames. However notice that the years where the 28% rally ends at a seasonally bullish point (end of year, new year, or the end of the summer swoon in August or September) pumps up the numbers. Years like 2009, 1929, and 1982 have this favorable tailwind.

The years most similar to 2012 (where the 28% rise ended on April 2nd) are the years were the 28+% rally ended in late March or early April, and they would be - 1991, 1987, and to a lesser extent 1975 and 1986. In these cases, the rise precedes a seasonally bearish period from May to August (thus the phrase 'Sell in May and go Away'). For these years, the 1,3 and 6 month average returns are - 0.54%, 3.43%, 0.24%. So the 1 and 3 month returns look similar to the overall calculation on Figure 1, but the six month return of 0.24% is substantially worse than the overall average. This is probably because the 'summer swoon' typically happens well into July (and therefore outside the 3 month window) when investors panic and their brokers are busy vacationing at the Hamptons.

So what can you take away from this analysis? If you're bullish, you can make the case for staying in the market and argue that at least you won't lose your shirt in the short-term. But there isn't much cause for comfort if you hold an index for 6 months or more. And if this analysis on rising stock correlations to indices has legs, then stock selection isn't going to be a cure all. I'm not suggesting the sky is falling, but at these elevated levels, don't jump into something that isn't a conviction buy. And if you do buy, be willing to weather some turbulence.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.